Markets & Finance

Arbeter: Time to Head for the Hills?

From Standard & Poor's Equity ResearchWe thought we had a selling capitulation in the financial sector two weeks ago. Guess again. Last week it was Citigroup (C). No matter who it is this week, the financial indexes and bond yields that we have been talking about are breaking the wrong way, and we think this has serious implications for the overall stock market. We see this as a good time to head for the hills for awhile and enjoy the refreshing fall weather and clear our head of all these crosscurrents. It feels like we are at a crossroad and there are signs pointing in 10 different directions. Then again, no one said predicting the future would be easy.

The S&P Financial SPDR (XLF) broke down on Friday, Nov. 2, as the recent closing low of 32 could no longer hold. This is the lowest close for the XLF since July 2006. With the break of support at 32, the index is susceptible to losses to the next layer of chart support down in the 27 to 30 range. This support is from a price consolidation from back in 2004 and 2005. The 50-day exponential average is below the 200-day exponential average, a bearish crossover, and both averages are declining. More importantly, the 17-week is below the 43-week average, suggesting the index has entered a bear market.

The KBW Bank Index (BKX) fell sharply last week, breaking to a new closing low. This index has actually been weaker than the XLF, as it fell to new lows during the middle of October, before meekly recovering major chart support around the 100 area. There was no doubt about it on Thursday, Nov. 1, however, when the index plunged 5.36%, its worst one-day decline since September, 2002. With the 2% loss on Friday, the index is now down 21% from its February high. The next major chart support for the BKX is in the 93 area.

The 10-year Treasury yield looks like it is hanging on by a thread, as it once again tests the important 4.3% level. On Friday, the yield dropped to 4.28% on an intraday basis but rose from there to finish right at important resistance. We believe that with the breakdown in the financials and the appearance that bond yields will follow, it will be very difficult for the overall market to make much headway, and we think that a wide trading range is the most optimistic forecast at this time. We also think that with sentiment having gotten so rosy, that we could eventually see an 8% to 12% correction in the intermediate term.

Market speculation can come in many forms and affect many different markets. We were surprised, after the beating the market took this summer, that bullish sentiment would rise so quickly and strongly. Sometimes sentiment moves in a slow, grinding process, and other times investors seem to turn on a dime. Not all of the sentiment indicators we monitor are showing extreme optimism, unfortunately, the majority are with some that measure what the individual is doing moving quickly into the "get me in at all costs" camp. Many times, this is when it is dangerous to be overweight equities.

The ISEE sentiment index jumped to 191 on Oct. 29, the highest reading since August, 2006. During the correction this summer, this index got as low as 51. This index is a call/put ratio based on opening trades by individuals. Recently, it has shown that individuals are rushing to buy calls relative to puts, a sure sign of bullish speculation. The most recent high for this index was at 187 on October 8, right before the slide into the middle of October. Prior to that, the index peaked at 186 and 181 during the early part of July, right before the downdraft last summer.

A second indicator we like to use to measure speculation in the marketplace is the ratio of Nasdaq volume to NYSE volume. The 3-week average of Nasdaq volume to NYSE volume hit 163% on October 19, the highest level during a bull market since early 2000. Prior highs during the current bull market ranged from 136% to 158%. Following each of these speculative readings, the market had a pullback or correction in the next four to eight weeks. If we look at this ratio on a 5-day basis, it reached 176% on Oct. 29, also the highest during the present bull market, and a clear indication, in our view, that the speculative juices are flowing.

Another way to measure speculation, at least these days, is to monitor the emerging markets. We think the price action of these markets makes it very obvious that emotions are running hot and that some air has to be let out of the bubble. The Hang Seng Index has taken out the psychological 30,000 level; unfortunately, we think the index is in a clear upside blowoff phase. We therefore advise caution. On a weekly chart, besides being extremely overbought, the price structure since 2003 looks very similar to the price structure of the U.S. stock market from 1982 to 1987. While it is tough to call a major decline, as they don't happen very often, we think the Hang Seng is susceptible to major damage, as the first piece of major support is over 8000 points below current prices, or about 26% to the downside.

As of the Oct. 29 close at 31,638.22, the Hang Seng index had risen 11,251 points since Aug. 17, or 55.2%. What we see as a parallel is that the U.S. stock market had a major blowoff in 1987, the fifth year of the bull market that propelled the S&P 500 39% in 8 months. The Hang Seng is in the fourth year of its bull market, but the charts look very similar. Both bull markets started off very strong, with the S&P 500 rising 67% in nine months off the '82 low, and the Hang Seng rising 68% in 10 months off the 2003 low. During the middle phase of the bull markets for each of these indexes, both grinded higher for a couple years, until they started going asymptotic. There is another similarity: the '82-'87 bull market advanced 229%, and, as of Monday's close, the Hang Seng had increased 279% from the '03 low.

The Hang Seng remains extremely overbought, and this suggests to us that we are closer to the top of an intermediate-term advance than to the bottom of the next correction. When looking at the spread between the 1-week and 50-week simple averages, the percentage difference as of Monday was almost 44%. This is the widest that these two averages have been apart since early 1994. The 14-week RSI is almost at 85, the highest since late 1993.

The iShares FTSE/Xinhua China 25 Index (FXI), at its recent high, had risen 82% since its Aug. 16 closing low. The index is very overbought and like the Hang Seng, we think it is much closer to an intermediate-term peak than the next corrective low. We believe the index is in the midst of a speculative blowoff and would advise taking profits.

It is possible that the FXI is tracing out a bearish double top. The problem is that there is very little chart support near current prices. There is minor support in the 187 area, but real strong support does not exist until the 140 to 155 zone. A move back to this zone of support would represent a considerable correction from current prices. The third Fibo extension, one that is very rarely reached, seems to have provided a ceiling for the index. This is based on a 423.6% extension of the most recent correction and lies at 218.

The 14-day RSI has traced out a negative divergence, and has also put in a lower low. The 14-week RSI is up near an all-time high of 85, and may be working on a very small but potentially damaging negative divergence. Many times, because of the speed of the FXI to the upside, weekly divergences do not have time to develop.

Another way to illustrate how overbought the FXI is, and to show that we are in potentially dangerous territory, is to take the difference between the 1-week and 50-week moving average. It is currently near 70%, or the highest difference in the history of the index. We believe this is quite rare for any index, and certainly is a warning that a top is probably near. Remember, these indexes can go down at least as fast as they went up.